Emerging Markets Insights

U.S.-based multinational corporations lost an estimated $50 billion as a result of currency volatility in 2012.  As I referenced in my previous post, FSG projects currency volatility to increase in 2013.  No longer can executives only rely on corporate treasury to manage these risks as the potential impacts on profitability and performance are too great.

To better understand some of the operational strategies that executives can use to reduce currency risks, FSG turned to one of our expert advisors, Professor Gordon Bodnar:

• GB: “I encourage companies to think about structuring their operations as much as possible to have flexibility to respond to unexpected currency movement.  If currency moves in our favor, can you take advantage of not just increasing dollar price and dollar revenue stream by providing additional service?  Same thing for operations on the downside, how are operations structured so that over the short-term you can make adjustments to the pricing or costs structure such that you see a devalued currency by 10% your costs rise by less than 10%”

• GB:  “In markets with high volatility, the goal is an options type payoff.  Companies often don’t want to do this, as anytime you are creating an option there is an upfront cost.  However, the point is that the payment of the premium is necessary to get the payoffs you want…you have the ability to absorb and move across the profitability curve, leading to a higher expected payout”

Larger initial  local investments give executives the flexibility to respond to FX volatility with operational rather than financial strategies.

This is obviously a more risky strategy, and Professor Bodnar was kind enough to share a wide array of less risky strategies that I’ll cover in future posts.

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Gordon Bodnar is the Morris W. Offit Professor of International Finance and Director of the International Economics program at The Paul H. Nitze School of Advanced International Studies. He is presently a research associate of the Weiss Center for International Finance and also teaches in the Wharton Executive MBA program at the Wharton School at the University of Pennsylvania. Dr. Bodnar is also the associate editor of European Financial Management, Journal of Asian Economics, and Journal of International Financial Markets, Institutions and Money. He has held appointments as a Research Fellow at the National Bureau of Economic Research and the IMF. He received his Ph.D. in Economics from Princeton University.

As an FSG Expert Advisor, Professor Bodnar is available to FSG clients for consultation on many business issues with key areas of expertise including corporate and risk management.  Please contact your account manager for further information or contact us at sales@frontierstrategygroup.com.

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“Currencies should not be used as a tool of competitive devaluation. The world should not make the mistake that it has made in the past of using currencies as the tools of economic warfare.”
- George Osborne, Britain’s Finance minister

For emerging market finance ministers, the concept and impact of “currency wars” is very real. As loose monetary policies in developed economies encourage high capital inflows to emerging markets (often referred to as “hot money”), emerging countries struggle to control inflation and the upward pressure on their currencies. This often leads to a surge in competitive devaluations as governments feel compelled to intervene in order to protect fragile domestic economic recoveries, which has the resulting consequence of amplifying currency volatility. However, these competitive devaluations should not be considered as “economic warfare”, they are economic stabilization measures and a natural result of expansionary monetary policy. As many media outlets implicitly (or probably explicitly) understand, conflict is much more exciting than accord. By emphasizing the antagonistic aspects of these decisions, they are unfortunately misleading the public into thinking that these interventions are purely for competitive purposes.

However, multinationals are impacted when emerging markets governments respond to capital inflows by more aggressively printing money to sell on the open market to buy hard currencies. The reality is that the selling of local currency to buy developed-market bonds creates a cycle that further depresses yields in developed markets, pushing more capital to emerging markets, restarting the cycle of currency volatility again. Unfortunately for international executives, currency volatility creates many problems, such as difficulties in:

1. Pricing products
2. Anticipating costs
3. Uncertain business planning
4. Greater reluctance to hire new employees
5. Price instability in commodity markets

For international executives that are increasingly focused on profitability, currency volatility is one of the most important trends to watch this year. For example, a 10% increase in profitability in a given market will be essentially wiped out by a 10% decrease in the value of the local currency when results are reported.

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Here’s a look at a few of this week’s global headlines with added commentary by our research team members:

Market Watch’s Post-Chavez Venezuela: oil’s next Saudi Arabia?:

“As Associate Vice-President for Latin America Clinton Carter is quoted in this article, oil production is unlikely to experience any increase over the short term, as a necessary shift toward investments in PDVSA are likely to continue to be secondary to the need to fuel social spending and support any post-Chavez government.”
- Antonio Martinez, Senior Analyst for Latin America Research

The Financial Times reports new property market cooling measures put doubt on China’s economic recovery:

“China has launched yet another round of of cooling measures, including a 20% capital gain tax on property sold in the secondary market, higher down payment and mortgages, to contain property prices. This is will impact property and construction related industries, which represent a big chunk of the Chinese economy, adding new pressure to the fragile recovery.”
- Shijie Chen, Practice Leader of Asia Pacific Research

Reuters had an article on Brazil’s industrial recovery:

“Any sustainable economic rebound in Brazil will have to be led by the industrial sector, making this heartening news for multinationals concerned about a seemingly interminable slowdown in Latin America’s largest market.”
– Ryan Brier, Practice Leader of Latin America Research

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According to Venezuela’s vice president, Nicolas Maduro, Hugo Chavez died at 4:25 PM, local time, on Tuesday from complications related to cancer.

FSG has been predicting for some time that it was unlikely that Hugo Chavez would be able return to lead the country, as his health has been in serious decline since he underwent his fourth cancer-related surgery in December.

While there might be a temptation for multinationals with operations in Venezuela to greet this news with cautious optimism, FSG stresses that executives should focus on managing expectations for any material change in the operating environment over the near-term.

The government is constitutionally mandated to hold presidential elections within 30 days; however, there is a possibility that this requirement could be ignored, with elections falling as far out as June.

Regardless of the timing of the elections, the most likely candidates will be Vice President Nicolas Maduro and Governor Henrique Capriles. FSG expects Maduro to win a clear electoral mandate due to a strong sympathy vote as well as the relative weakness of the opposition, which is still suffering the after effects of two big electoral defeats at the end of 2012. Recent poll results casting Maduro as a legitimate heir to Chavismo bear this prediction out.

Given Maduro’s ideological affinity for the key social tenets of Chavismo, as well as the fact that most legislators will not be up for reelection until 2015, it is highly unlikely that multinationals will see any major policy adjustments over the near-to-medium term. The one exception to this is a probable second devaluation sometime after the elections, along with the establishment of a new parallel exchange rate system to replace SITME.

The long-term picture is somewhat more optimistic as it is unlikely that Chavismo will hold together as a cohesive political force without a strong and charismatic leader at the helm. As such, there is a strong possibility that the opposition will slowly gain strength, leading to a modest opening of the economy to investment over the next few years. While this would be a welcome scenario for multinationals, it is also one fraught with a good deal of risk if the fragmentation of Chavismo leads to social unrest and instability.

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Many of this week’s US headlines primarily focused on the the imminent United States government sequestration.  In addition to following those developments, our research talent kept an eye on headlines pertaining to emerging markets, too.  Below are some headlines with FSG research analyst commentary:

Bloomberg News reported that Emerging Stocks Erase Weekly Gain on China, Commodities:

“Today’s headlines highlight the US budget sequester’s ripple effect on emerging-market growth. That could incrementally diminish the opportunities for MNCs in some EMs, but it doesn’t change the fundamentals. We are more concerned that US-based MNCs will react to economic mismanagement at home by remaining overly risk-averse abroad, allowing local competitors to capture yet more market share.”
- Joel Whitaker, Senior Vice President and Head of Global Research

The Wall Street Journal’s Deal Journal blog posted Doubts Over Returns Hit Fundraising in China:

“Look beyond headline GDP to gauge China’s economic performance. Look at corporate profits in China and return of PE investment is a good indicator.”
- Shijie Chen, Research Practice Leader for Asia Pacific

From Reuters - Brazil may use imports to curb inflation:

“Offhand comments by Brazil’s finance minister raise the possibility that the country could drop import tariffs in sectors and on goods where local producers have been raising prices aggressively. This would be a 180 turn from years past, when Brazil raised tariffs on imported goods in industries impacted by cheaper imports due to a strong currency.”
- Clinton Carter, Director of Research for Latin America

And lastly, another article from Reuters - Russia says central bank independence not at risk:

As CEE governments struggle to boost growth without increasing fiscal deficits, they are increasingly pushing regional central banks to cut interest rates, even at the expense of undermining the banks’ independence. This is a trend to watch in 2013, especially in Russia where reduced central bank autonomy could significantly undermine investor confidence.”
- Martina Bozadzhieva, Senior Analyst for Central and Eastern Europe

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Frontier Strategy Group’s survey of senior business executives was recently featured in a nationally syndicated article by Amy Guthrie of Dow Jones Newswire. The article, which was picked up by major news companies like Fox Business, highlighted Latin America’s high-profit performance relative to other emerging market regions.

FSG’s proprietary benchmarking data obtained from a survey of executives at multinational companies operating in Latin America’s emerging markets was highlighted in the piece as a solid indication that Latin America is well-poised for further growth.  Ryan Brier, Practice Leader for Latin America at FSG, was interviewed for the news piece and delivered further insight to the high-performing Latin America region:

“Optimism is skewed toward the region’s second-biggest economy, Mexico, aided by the country’s overhaul agenda and improved manufacturing competitiveness, as well as toward Colombia, whereas the outlook for Brazil is less certain given a slowing economy, burdensome regulation and a generally high cost of business in the region’s biggest economy. Yet executives still see Brazil’s long-term potential as promising, given the country’s large youthful population and natural-resource potential.”

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In this podcast interview, FSG expert advisor Chris Gilbert discusses practical steps for building a successful regional expansion strategy in Russia with Martina Bozadzhieva, FSG’s Senior Analyst for Central and Eastern Europe.

Key points discussed include:

1.  Developing a process to select regional markets in Russia; gathering the necessary information to properly evaluate secondary markets in Russia beyond Moscow and Saint Petersburg.

2.  Identifying key resources in the regions to assist Russian expansion and how to navigate government and non-government agencies while mitigating exposure to government corruption.

3.  Managing the internal conversation and overcoming the reluctance from corporate to expand in Russia, a high-risk market.

To listen to or download the podcast, click on this link to access the iTunes store.

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Chris Gilbert has extensive commercial and managerial experience in Russia with a proven track record of increasing sales and developing new income streams in Russia.  Chris currently serves as the Regional Development Director at IAL Group Limited where he is responsible for developing the international and local client base within key regions of Russia.  Prior to his work at IAL Group Chris was the Russia Director at Russo-British Chamber of Commerce serving as the bridge between Russian and British businesses to foster successful and profitable UK-Russia relations.

Chris is fluent in written and spoken Russian and is available to FSG clients for Russian business strategy consultation on request.  Please feel free to email us at sales@frontierstrategyroup.com or contact your account manager if interested in scheduling time with Chris.

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Recent economic headlines reflected what FSG’s research reports have indicated around the world.  Ranging from the economic implications of the Syrian civil war to Argentina’s controversial elections and Estee Lauder’s successful EM portfolio, here are a few articles that our analysts read this week pertaining to emerging markets:

Estee Lauder reported big success in emerging markets via MSN Money online Emerging markets drive Estee Lauder’s profit growth:

“Not surprising that the Asia Pacific region was the largest contributor to Estee Lauder’s sales growth.  From a global perspective, we are noticing an uptick in consumer goods companies that are prioritizing the strong consumer environments available throughout the region.”
-Sam Osborn, Senior Analyst

The Financial Times’ Beyondbrics blog, centered on emerging market news, posted an interesting entry about Vote buying in Latin America:

“The numbers validate FSG’s view that Hugo Chavez essentially bought his reelection in 2012 with huge increases in public spending, for which the country is now suffering a hangover. This article highlights other countries with a strong propensity to inflate the economy prior to elections, of relevance in 2013 to the growth outlook in Ecuador and Argentina in particular.”
-Clinton Carter, Head of Latin America Research

The Washington Post reported Syrian business exodus gains pace:

“Syrian businessmen are shifting their investments, operations, and focus abroad amid increasing chaos of the civil war.  FSG mentioned how this impacts Jordan and Lebanon in the recently released MENA regional overview. This article also cites examples involving Egypt and the UAE.”
- Matthew Spivack, Practice Leader for the Middle East and North Africa

*Post compiled by Hal Olson

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Israel’s surprise election results indicate that the population is much more interested in the immediate need to stabilize the economy than in the country’s ongoing problems with Iran. This decreases the risk of an Israeli attack on Iran in 2013, and increases the risk facing Russia’s economy. The connection between the two? Predictably, oil prices, which are artificially high due to a political risk premium related to a potential Israeli attack on Iran.

For Russia, reduced oil prices mean significant economic as well as political risk. Sources as diverse as ratings agency Standard&Poor’s and the Russian Ministry of Economics point out that at US$80/bbl Russia’s economy will, at best, slow to a shallow recession. This will be accompanied with rapid and deep currency depreciation, rising inflation, and plummeting consumer spending and business investment. Frontier Strategy Group estimates that there is a 25% chance that this scenario could play out as early as this year, particularly after the Israeli election results.

Surprisingly, few multinationals operating in Russia have plans in place to respond to this scenario. Executives responsible for Russia are, of course, aware of the theoretical possibility of an oil price crash and its potential impact on the economy, but, as with any long-standing risk, they can become gradually de-sensitized to it, focusing instead on more short-term priorities such as growing their business’ presence in Russia’s regions, setting up local manufacturing, or forging new local partnerships. This approach, however, increases their business’ exposure to the market and their potential losses when a macroeconomic shock does materialize. Even if executives get everything right in their business strategy in Russia, an economic crisis could obliterate their success and throw off the most carefully-constructed plans. At the same time, an economic crisis could create unique opportunities to pursue M&A, capture talent, and take market share away from struggling competitors. Companies that are caught by surprise by a sudden change in the economic environment will struggle to both mitigate the risks and take advantage of opportunities created.

This context calls for careful contingency planning. However, contingency planning is frequently done on the corporate level and building a contingency plan for just one, often non-core, market, like Russia, is rarely a corporate priority. The organizations with the biggest stake in preparing such a plan – an EMEA or CEE division, and the local Russia team, frequently lack the resources and the expertise to build a sophisticated contingency plan. More often than not, bridging this gap requires regional organizations to reach out to corporate for support and guidance and to then take the initiative to build the plan in collaboration with their Russian team.

Not only does this process create an “insurance” for the organization when the risk of an oil price decrease does eventually materialize, but the planning process itself frequently yields actions that can be taken now, outside of the context of a crisis, to strengthen the company’s competitive position in the market.

*Listen to our  latest podcast on the Russian business landscape on iTunes.

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Frontier Strategy Group’s latest research on channel management in emerging markets was featured on the Financial Times’ beyondbrics blog on January 23, 2013. Please find the article below:

With major EM economies slowing in 2012, regional heads of multinational companies are increasingly having to focus on their margins. As new research from the Frontier Strategy Group shows, many are considering boosting them by running some of their own distribution operations.

In a survey of 136 executives from 82 multinationals operating across emerging markets, FSG found their respondents to be none too happy with their distributors. On average, EM distributors take a 25 per cent cut of revenue, and nearly two thirds of respondents said they were planning to work towards a better deal.

Joel Whitaker, head of global research at FSG tells beyondbrics that MNCs moving into emerging markets have conventionally “focused on capturing opportunities as broadly as possible as quickly as possible, leading them to rush into relationships which give considerable power to local distributors.”

You might think that with an in-demand product and a good brand, an MNC should hold the whip hand. However, due largely to their lack of local knowledge, 94 per cent of companies surveyed used indirect distribution channels, so switching between channels is not always easy.

Healthcare, for example, says Dan Kornfield, FSG’s director of strategic research, is “usually defined by a set of big distributors with relations with government. This creates an odd balance of power, where the middle man may be more picky than the supplier.” In more high tech enterprises, such as chemical engineering, the time taken to train distributors can be an additional bind.

Russia stands out in the survey as a particularly hard place to manage distribution. Of the four Brics it stands out as having the lowest average number of distributors per company at just five, compared with 174 in China, 39 in Brazil and 70 in India. It also has the largest average cut taken by distributors at 31 per cent – compared with 25 per cent in China and Brazil and 19 per cent in India – and the highest levels of dissatisfaction with distributor transparency, at 80 per cent.

Russia is defined, says Martina Bozadzhieva, a CEE researcher at FSG, “by a lot of small distributors with great local knowledge but insufficient resources to cover large distances, and a few very large distributors which can”.

The latter companies will often be handling goods from competitors too and consequently, Bozadzhieva says, “are touchy partners to work with. They give you fast geographic access, but they are hard to incentivise, and would not mind if you dropped out.”

Overcoming this could entail DIY distribution: 43 per cent of survey respondents said they were planing to move into direct distribution in at least one of their market segments, and 18 per cent said they were planning to acquire at least one of their distributors.

Alcoholic beverage companies in Latin America, FSG say, have demonstrated how it can be done successfully. “They have mapped out the networks, they know the logistics, they know what it takes to hire the right people – they have realised they can cut out the middle man,” says Kornfield. This comes not only with extensive experience of the local market, he says, but with a strong brand to wield.

When this experience is lacking, though, high risks are involved. Where choice of distributors is limited, causing offence can be costly, and what causes offence can vary from place to place.

“There is huge variation geographically around how easy it is to disengage with distributors”, Whitaker says. “Business in India tends to be more transactional, and that is very familiar to companies from western markets, a lot of their toolkit works well there.

“But a company in Indonesia that tries to rip up a distribution relationship is going to find it much more difficult. The consequences can be quite severe as it’s seen as a more personal relationship.”

And then of course, it might be all too easy to look enviously at the cut being taken by distributors and assume it would be easy to replicate.

“We had a client in consumer goods in Nigeria who was dissatisfied with its distributors. Getting the goods into market was very slow and costly, and because they had the resources they thought they’d go direct”, Bozadzhieva says. “They found it was very challenging, the cost increased, their competitive position deteriorated, and eventually they had to re-enter from scratch with a new distributor.”

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